Dollar Faces Gathering Headwinds

Only a few weeks ago, the dollar was powering towards its highest levels in four years, the beneficiary of widespread gloom about Europe’s debt crisis and rising optimism about the US recovery.

Since then, investors have soured on the world’s largest economy. The dollar has tumbled 9 per cent on a trade-weighted basis in two months, and on Wednesday fell to Y85.29, within a whisker of a 15-year low.

The sickly euro, by contrast, has recovered sharply, rising above $1.32 on Wednesday to a three-month high. Sterling is now at its highest for six months and approaching $1.60. “If the currency markets were a human being it would be locked up in a lunatic asylum at the moment,” says David Bloom, head of currency strategy at HSBC. “One moment it is extreme joy, the next moment extreme sadness. It’s extraordinary. We’re just swinging violently from one extreme view to another.”

A wave of weak economic data, including disappointing jobs figures, and expectations of further monetary easing by the US Federal Reserve to head off the risk of a double-dip recession have been the main drivers of the dollar’s fall.

Investors fear the US recovery, undermined by anaemic demand in spite of evidence of improving corporate earnings, could be about to peter out or, worse, go into reverse.

Theslide in the dollar over the past week, in which it has fallen by more than 2 per cent against a basket of currencies, was triggered by the spectre of deflation. James Bullard, president of the St Louis Federal Reserve, said the US was “closer to a Japanese-style outcome today than at any time in recent history”.

Those comments, and remarks by Fed chairman Ben Bernanke on Monday that there remained a “considerable way to go” before the US made a full recovery have increased expectations of further easing by the Federal Reserve. Fed officials are debating whether to maintain the size of the balance sheet by reinvesting money from maturing government bonds.

Traders say the currency and government bond markets are now pricing in just such a move when the Fed meets on Tuesday. “It feels like you’re in a boxing match, it’s round number nine and they’ve softened you up for a blow,” Mr Bloom says. “If they do something on ‘quantitative easing’ the market will already have got its head around it. They’ll have softened us up.”

As investors pull money out of the greenback, they are betting the recovery in other parts of the world will outpace that of the US. Asian countries, expected to enjoy stronger growth than the debt-burdened west, have enjoyed strong inflows of funds in recent months.

In July, net inflows from foreign institutional investors into the Indian equity market totalled $3.8 billion. The Korean and Taiwanese equity markets each received net inflows of more than $2 billion last month. These flows have boosted the region’s currencies. The Singapore dollar is flirting with a record high, while the Indonesian rupiah and the Malaysian ringgit have risen to their highest in more than a year.

The conditions are building, too, for a return of the dollar “carry trade”, in which investors take advantage of low US borrowing costs to invest in higher-yielding assets elsewhere. Given the weaker outlook for the country’s economy, US interest rates are expected to stay on hold at least until late 2011. Hans Redeker, head of currency strategy at BNP Paribas, says his bank’s measure of “carry risk” has peaked, an auspicious signal for for carry traders.

In addition, Volatility has also fallen in the past two months, providing the stable conditions needed for a successful carry trade.

One dollar carry trade has involved buying Indonesian bonds. Foreign ownership of Indonesian bonds has risen to a record, while bond yields – which move inversely to prices – have fallen to record lows. Estimating the size of the dollar carry trade is an inexact science. Tim Lee at Pi Economics, a consultancy, says the dollar carry trade may now be worth more than $750 billion, approaching the size of the yen carry trade at its peak in 2004-07. A revival of the carry trade would put further downward pressure on the US currency. In the short term, though, the currency’s direction is likely to be determined by the Fed’s action on Tuesday, with traders saying anything short of a move to ease policy further is likely to disappoint the market.

Tomorrow’s US non-farm payrolls data, a closely watched set of jobs figures, will therefore assume even more importance than usual. Consensus forecasts are for a rise in the unemployment rate.

Some investors are speculating that Asian policymakers could support the dollar. The yen’s surge has strengthened the view in the markets that the authorities might react. Yoshihiko Noda, Japan’s finance minister, on Wednesday said the yen’s moves had been “somewhat one-sided”, adding that he was “closely watching market moves”.

But analysts and traders are not expecting the finance ministry to directly buy dollars to weaken the yen, a move it has not made since 2004 – not least because G7 countries have been encouraging exchange rate flexibility, especially in China.

Also, even though on a nominal level the yen is approaching highs it has not seen since 1995, on a real trade-weighted basis it is a different story.

BoJ data compiled by UBS show the real trade-weighted yen exchange rate is far lower than its early 1990s highs.

In the longer term, the success of the dollar carry trade will depend on the US economy remaining weak while the world around it continues to power ahead.

“It is a bit of a tightrope,” says Mr Lee. Any deviation from the current picture of stagnating growth in the US would cause the dollar carry trade to be unwound, pushing the greenback higher, he says. “If you’re a real bull and you think we’re just in the early stage of a recovery you have to assume interest rate rises are going to come sooner. But if we’re going back into severe recession, then we’ll go back into severe risk aversion and the carry trade will be unwound because everyone will be pulling in leverage.”

Mr Redeker at BNP Paribas says: “This is a summer market, this is a carry trade environment ... By autumn, it will be a perfect opportunity to bet against it.”